Where Y* is potential output and u* is the "natural" rate of unemployment

Costs of high unemployment

Aggregate supply

The modern Phillips curve: π = πe - B(u - u*) + S

Where: π is the inflation rate, πe is expected inflation, u* is the natural rate of unemployment, and S is a supply-shock term.

What is expected inflation? We will deal with that later...

When unemployment is at its natural rate u*, inflation is at its expected value πe, and vice versa

Monetary policy, aggregate demand, and inflation

Think of the Federal Reserve choosing three numbers--a "normal" level of unemployment, a target level of inflation, and a degree of aggressiveness in response to deviations of inflation from the target--as follows:

The Federal Reserve chooses a value of the interest rate r

(A gross shortcut, but let's make it)

When the Federal Reserve's choice of the interest rate r is at its normal value, then we go to the IS curve:

Y = A0/[1-MPE] - (Ir + Xeer)/[1-MPE]

Where A0 = C0 + I0 + G + XfYf + Xee0 + Xeerrf

And find that Y is at some value Y0, and thus that the unemployment rate is at value u0--what the Federal Reserve thinks is the "normal" value of the unemployment rate

We model this with John Taylor's Monetary Policy Reaction Function (MPFRDF):

u = u0 + o(π - πT)

Equilibrium

We have:

u = u0 + o(π - πT)

π = πe - B(u - u*) + S

And thus:

π = πe/(1+Bo) + πT/(1+Bo) - B(u0 - u*)/(1+Bo) + S/(1+Bo)

Give us a rule for understanding how inflation expectations are formed, and we will be done.

Inflation expectations

Three kinds:

Static

Adaptive

Rational

Static inflation expectations

Will exist only if fluctuations in inflation are small

Produces an economy that moves back and forth along a stable downward-sloping Phillips curve

π = πe/(1+Bo) + (Bo)πT/(1+Bo) - B(u0 - u*)/(1+Bo) + S/(1+Bo)

u = u0 + o(π - πT)

With static expectations, only the sticky-price model is relevant

The U.S. in the 1950s and 1960s

Rational inflation expectations

Will exist in a sophisticated economy if the variation in government policy and in inflation is large

Produces an economy with a vertical Phillips curve (except for supply shocks): unemployment = u* plus supply-shock terms; changes in government policy and in the economic environment affect the rate of inflation only

r is now a fixed, given variable--the result of Federal Reserve policy (or of the current money stock and money demand) plus other influences
C + I + G + (X - IM) = Y is now an equilibrium condition--not an identity

And we derived:

Output as a function of autonomous spending A:

A = I + G + X + C0
Y = A/(1-(Cy(1-t) - IMy))

The multiplier: 1/(1-(Cy(1-t) - IMy))

Now let's go one step further...

Investigating the dependence of autonomous spending on the real interest rate r, and thus of output on the real interest rate r...

Interest Rates and Planned Expenditure

The importance of investment spending

The interest rate is not set in the loanable funds market in the sticky-price model

The interest rate is set by a combination of

Demand and supply for liquidity--money, and

The term structure of interest rates

Hence no presumption that fluctuations in investment--whether driven by "animal spirits" or movements in interest rates--are stable or stabilizing

Why investment depends on the real interest rate

The long-term, risky, real interest rate

Exports and autonomous spending

The exchange rate depends on the interest rate

Exports depend on the exchange rate

Hence exports are another interest-sensitive component of autonomous spending

The stock market as an indicator of investment

The IS Curve

Autonomous spending and the interest rate

From the interest rate to investment to planned expenditure

The slope and position of the IS curve

(Inverse) Slope: (1-MPE)/(Ir + Xeer)

Position: A0/((1-MPE)

Equilibrium

Moving the economy to the IS curve

Interest rates adjust immediately

Inventories: output and demand levels adjust more slowly

Shifting the Is curve

Example: a change in government purchases

Moving along the IS curve

A change in monetary policy: open market operations

Difficulties in monetary management

Using the IS curve to understand the U.S. economy

The 1960s: Federal Reserve keeps interest rates stable; Great Society and Vietnam War shift the IS curve outward

r is now a fixed, given variable--the result of Federal Reserve policy (or of the current money stock and money demand) plus other influences
C + I + G + (X - IM) = Y is now an equilibrium condition--not an identity

Sticky prices

Consequences of sticky prices

Flexible-price logic: prices adjust

Sticky-price logic: quantities adjust

Expectations and sticky-price logic

If expectations are fulfilled, then there will never be cases when price stickiness matters: it's only price stickiness plus surprising changes to economic policy or the economic environment that causes deviations from the full-employment model of chapters 6 and 7
*Why are prices sticky?

r is now a fixed, given variable--the result of Federal Reserve policy (or of the current money stock and money demand) plus other influences
C + I + G + (X - IM) = Y is now an equilibrium condition--not an identity

And we derived:

Output as a function of autonomous spending A:

A = I + G + X + C0
Y = A/(1-(Cy(1-t) - IMy))

The multiplier: 1/(1-(Cy(1-t) - IMy))

Now let's go one step further...

Investigating the dependence of autonomous spending on the real interest rate r, and thus of output on the real interest rate r...

Interest Rates and Planned Expenditure

The importance of investment spending

The interest rate is not set in the loanable funds market in the sticky-price model

The interest rate is set by a combination of

Demand and supply for liquidity--money, and

The term structure of interest rates

Hence no presumption that fluctuations in investment--whether driven by "animal spirits" or movements in interest rates--are stable or stabilizing

Why investment depends on the real interest rate

The long-term, risky, real interest rate

Exports and autonomous spending

The exchange rate depends on the interest rate

Exports depend on the exchange rate

Hence exports are another interest-sensitive component of autonomous spending

The stock market as an indicator of investment

The IS Curve

Autonomous spending and the interest rate

From the interest rate to investment to planned expenditure

The slope and position of the IS curve

(Inverse) Slope: (1-MPE)/(Ir + Xeer)

Position: A0/((1-MPE)

Equilibrium

Moving the economy to the IS curve

Interest rates adjust immediately

Inventories: output and demand levels adjust more slowly

Shifting the Is curve

Example: a change in government purchases

Moving along the IS curve

A change in monetary policy: open market operations

Difficulties in monetary management

Using the IS curve to understand the U.S. economy

The 1960s: Federal Reserve keeps interest rates stable; Great Society and Vietnam War shift the IS curve outward

r is now a fixed, given variable--the result of Federal Reserve policy (or of the current money stock and money demand) plus other influences
C + I + G + (X - IM) = Y is now an equilibrium condition--not an identity

Sticky prices

Consequences of sticky prices

Flexible-price logic: prices adjust

Sticky-price logic: quantities adjust

Expectations and sticky-price logic

If expectations are fulfilled, then there will never be cases when price stickiness matters: it's only price stickiness plus surprising changes to economic policy or the economic environment that causes deviations from the full-employment model of chapters 6 and 7
*Why are prices sticky?

September 19: Lecture: Building Up the Flexible-Price Full-Employment Business-Cycle Model

For the past couple of weeks we have been looking at long-run growth. Now we turn to looking at much shorter-run phenomena: business cycles. For the next couple of weeks we are going to be in a halfway house: looking at the economy over a period short enough that we can take its productive capacity to be fixed, but long enough that we can take wages and prices to be sufficiently flexible that supply and demand in the labor market balance and that the economy is as a result at "full" or "normal" employment.

Potential Output

In this model, actual output is equal to the economy's productive potential (as discussed in the long-run economic growth section).

And by the circular flow principle output == national income == aggregate demand

Why? Because wages and prices are flexible so that unused and idle resources are few

A mystery: why is the average--the "natural"--rate of unemployment so high? Why is it 5% or so rather than 1%?

The production function (go back to your "economic growth" notes and to chapter 4)

How much does investment depend on cash flow--and thus on the level of output Y?

In this our model, we say that consumption depends on Y (but not on r) and that investment depends on r (but not on Y). If we have time we may relax this assumption and allow both to depend on both)

Government purchases G we leave to the political scientists

Note: government purchases, not government spending

The International Sector

Imports depend on Y alone: IM = IMyY

Exports depend on foreign incomes and on the exchange rate:

Our exports equation: X = XfYf + Xee

Note: the peculiar sign of our exchange rate convention...

The exchange rate

Greed and fear--speculators fear capital losses but want current income

Our exchange rate equation: e = e0 + er(rf-r)

Today we have done nothing but build up the behavioral relationships that are the building blocks of our flexible-price full-employment business-cycle model. Putting the pieces of this model together we will do on Wednesday.

Even after Wednesday, we will still be far from having a complete picture of business cyles. We won't have integrated cycles with growth; we won't have even started to think about demand-driven fluctuations in output and unemployment; and we won't have thought about the price level and the inflation rate.

Skin color as a marker of slave status in the Americas: it kept slavery going for centuries after indentured servitude (which did not use skin color as a marker) broke down

Woolier and unsubstantiated stories:

Jared Diamond on how people in Papua New Guinea are smarter than the rest of us

In northern latitudes keeping warm is important: selection for dumpy and less athletic body types?

But don't go there: evolutionary behavior is still nothing more than a source of just-so stories, and has been a source of immense ignorance and terror in the past

The way to think of it, I have been told, is that there is less genetic variation in the entire human race than in a single baboon troop

Hunter gatherers
* Pretty ferocious--even East African Plains Apes of two million years ago could drive hyenas from their dens
* Sophisticated Cro-Magnon technology
* Sophisticated Cro-Magnon culture--doing a lot of things that mark them as fully human
* Life was nasty, brutish, and short--but athletic
* Cro-Magnon hunter-gatherers
* Average menarche at 16?
* Life expectancy of 25?
* Seven pregnancies to term?
* But infinitesimal population growth means ferocious infant mortality
* But they were buff: adult male heights of 5'8" or so

This is the syllabus for the first half of Economics 101b, Macroeconomics. It carries the course up until October 12. The syllabus for the second half will be distributed at the end of September. It will depend on (a) how well the class does in the month of September, and (b) what are currently "hot topics" in the economic news. The U.S. budget deficit, the looming possibility of a major U.S. dollar-financial crisis, the dilemmas of Federal Reserve policy, and the ongoing industrial revolutions in East and South Asia will certainly be on the second-half syllabus, but there will be other topics as well.

This is the go-faster and do-more version of macroeconomics--the study of the determination of output, production, income, employment, and prices in the economy as a whole. Four books are required:

Since this is a go-faster do-more course, we will go faster and do more. As a group, the class will be made up of people comfortable using calculus, so we'll feel free to use it in lectures, handouts, and in problem sets (and on exams). If you aren't comfortable using calculus, you probably don't belong here and may well not have a good time...

We--Suresh Naidu and I are keenly aware that almost everybody signing up for this course could alternatively take and do very well in Economics 100b. We are anxious not to have students vote with their feet for an easier course and learn less because they fear the consequences of lowering their grade point average. Therefore this course will have a high curve: the idea is that nobody should get a lower grade than they would have gotten had they decided to take Economics 100b instead: Grades will be based on the following:

30% from a (short: two hours long) Final Exam to be given Tuesday December 13 8-11 AM

20% from a first Midterm Exam to be given Wednesday September 28. (This is really early to give a midterm. Nevertheless it is important to give a midterm exam early in the course to serve as a reality check: so that students in trouble can figure out how much trouble they are in, and also--more important--so that at least one of us (DeLong) can figure out how unrealistic and detached from reality his beliefs about his teaching effectiveness are.)

20% from a second Midterm Exam to be given November 13.

20% from Problem Sets and other assignments to be due at the start of section. Problem Sets will be graded either 0 points (didn't hand it in at start of section), 1 point (handed it in but didn't make an effort), and 2 points (made an effort--whether successful or not--to solve all the problems).

10% on section participation.

No makeup exams will be offered. Students who miss one of the three exams will have their scores for the other exams reweighted to add up to 70%. Students who miss two of the three exams should not expect to pass.

F Sep 30: Sticky Prices, Consumption, and the Multiplier (problem set 4 issued)
M Oct 3: Investment and the IS Curve
W Oct 5: Using the IS Curve to Understand the Economy
F Oct 7: Inflation and the Phillips Curve (problem set 5 issued/problem set 4 due)

Sections. Go over midterm. Cover Blanchard (1981).

M Oct 10: The Natural Rate of Unemployment and the Federal Reserve
W Oct 12: From the Short Run to the Long Run
F Oct 14: Understanding American Business Cycles Using the Phillips Curve/Monetary Policy framework (problem set 6 issued/problem set 5 due)